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Biotech: dip or bubble?

Biotech stocks have stumbled, but, it could be an opportunity to buy at lower valuations.

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Biotechnology stocks have performed strongly for nearly five years, with the MSCI U.S. Investable Market Biotech 25/50 Index delivering average annual returns of 27.4%. But amid questions about pricing policies and concerns about valuations, the sector began a sell-off in early March that continued through mid-April.

While some biotech stock have rallied in recent days, investors may be wondering "What’s next? Rajiv Kaul, portfolio manager of Fidelity Select Biotechnology Portfolio, thinks the recent downturn could represent a opportunity amid a long-term trend of innovation and growth for the sector. At the same time, he notes the industry has a long history of volatility. Still, he thinks that investors should not be deterred, but should instead use these swings as opportunities to selectively buy better stocks—with exceptionally qualified management teams, diversified pipelines, and strong cash positions—at lower prices.

What has driven the downturn?

Kaul:There has been some concern in the media around drug pricing. Recently the discussion has been around the pharmacoeconomic value of new drugs like recent innovations that cure hepatitis C. I’m optimistic that the industry will overcome these concerns as these newer medications in fact provide tremendous cost savings to payers over the long-term. For instance, new hepatitis C treatments may avoid costly liver transplants, hospitalizations, and death.

This topic isn’t new—for more than two decades the industry has had to focus on developing innovative drugs that provide both cost-effective healthcare solutions and great outcomes for patients.

At this point, I think the likelihood that there will be changes to the way the industry pays for drugs are pretty low, so the market may have overreacted to this issue.

How should investors manage volatility?

Kaul: When you invest in the biotechnology industry you should expect volatility. Historically, such volatility has been beneficial to those who have taken a longer-term view. For instance, prior to this pullback, there have been seven corrections of 10% or more since 2001, based on the NASDAQ Biotechnology Index. But the one-year return following these pullbacks averaged gains of more than 50% from the low-point.

While past performance doesn't guarantee future results, I look at the volatility in the biotech market as a long-term opportunity. Over the last five years the biotech industry has performed very well, and over the next three, five or 10 years, I think biotech has the potential to remain a really exciting place to be. The fact is, in a matter of weeks the stocks have become cheaper now and sentiment has suddenly tuned bearish. That gives investors a chance to buy the best companies at better prices.

As you can see below, the biotech industry has historically provided higher returns than the S&P 500®, but with two times the volatility.

So you don’t see any fundamental challenges with the biotech sector?

Kaul: I hesitate to generalize about the health of the entire industry—but I would say there are many promising macro trends that bode well for the development of breakthrough medicines over the longer term.

It’s important to realize that returns in the biotech space are really driven by stock picking. Every company is different. If a company has a molecule that aims to cure cancer, it’s different from a molecule that’s going to work against a deadly viral disease. So companies are very distinct, and their long-term returns can vary more from one stock to another than in most sectors. If you can pick a winner, you can do extremely well. So picking the right company, which can have a successful product, is key to generating superior returns over the long term.

Discovering a drug that’s going to change people’s lives and change the way medicine is practiced is a very difficult process. The science is hard, and the process is very risky and prone to failure. Most drugs that go into clinical trials fail, and it costs a lot of time and money—hundreds of millions of dollars—to get regulatory approval. There’s a high hurdle to clear. But, if a company can make the transition from research and development to a real business, it has a very high barrier to entry and can transform into one of the best businesses. Successful biotechs have the potential for a very long product cycle, a great deal of cash-flow generation, and the ability to spend more money to get a second or third drug into the market. So I would reiterate that selectively picking the successful products and companies based on bottoms-up fundamental research is the key to investing in this industry, in my view.

I believe there are still companies in the industry that provide attractive opportunities—and the recent pullback in stock prices has made it easier to find those opportunities.

What characteristics should investors look for when picking biotech stocks?

Kaul: I’m a value investor in biotech. So I look for stocks where I believe the price justifies the risk. Right now, some of the larger companies in the industry are trading at a discount to the S&P 500 on a forward price-to-earnings basis. No one knows what’s going to happen in the short term, but if you’re getting good fundamentals at a cheap price and you’ve got a long-term view, you can choose from among the best and most innovative businesses in the world.

Where have you been seeing the most interesting opportunities?

Kaul: Oncology is one area where a lot of great drugs are being developed. Likewise, there are a lot of interesting things happening in virology, including drugs to treat viral diseases like HIV and hepatitis C. And then there are orphan diseases: In the last five or 10 years it has become possible to genetically identify groups of people who have a serious disease that’s based on a malfunctioning of a specific gene. As a result we can develop gene-specific, targeted therapies that can greatly benefit these patients. There are ongoing advancements in cheap diagnostics, which are creating a host of ways to create personalized medicines. These advances have the promise to dramatically improve outcomes for selected patients whose diseases are defined by specific genetic factors, while simultaneously reducing costs to the system. For example,the ALK inhibator (crizotinib) is a new way to treat non-small-cell lung cancer.

Have any individual stocks looked particularly attractive to you?

Kaul: Amgen Inc. (AMGN) has been trading at a relatively cheap valuation. It has recently traded at a mid-single-digit free cash-flow yield—free cash flow per share divided by its share price. What’s more, it has had a promising pipeline with seven late-stage drugs, many of which could be game-changing. I believe Wall Street has been underestimating the future growth profile of the company, which looks promising to me and the valuation appears pretty reasonable.

Regeneron Pharmaceuticals, Inc. (REGN) is another company worth mentioning. It has had very positive results for a new cholesterol drug, PCSK9, which could serve a very big market. This could be an extremely promising new class of drugs for the millions of patients who suffer from high cholesterol. In addition to PCSK9, Regeneron’s lead drug, EYLEA,® which treats age-related macular degeneration, is growing rapidly.

A lot of biotech companies—about 70—have gone public in the last year. Many of them have corrected pretty dramatically in the last six weeks, and I think some of those companies, along with the more stable, larger companies, provide great investment opportunities. This industry is prone to this bubble-and-bust mentality. There may have been overenthusiasm around some of the newer issues, but now a lot of them have given up most of their gains and have looked very cheap compared to what they can potentially deliver.

Where do you see the biotech industry heading in the next five to 10 years?

Kaul: In the next 10 years, we could get approximately five hundred new companies, in addition to the hundreds we have today. As a result, I’m hopeful there will be many exciting investment opportunities. This industry is at a promising moment of great innovation and great growth—I view it as a golden age for developing breakthrough medications. But investors need to understand that biotech is different from other types of stocks, and investors need to keep a consistent, long-term view. They may want to consider allocating a small part of their portfolio to biotech, and they should look beyond short-term volatility. When sell-offs like this happen, I see them as an opportunity to buy great companies at cheaper prices.

Learn more

  • Rajiv Kaul manages Fidelity® Select Biotechnology Portfolio (FBIOX).
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Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information.  Read it carefully.

Views expressed are as of the date indicated and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the speaker or author, as applicable, and not necessarily those of Fidelity Investments.

Any such views are subject to change at any time based upon market or other conditions and Fidelity disclaims any responsibility to update such views. These views should not be relied on as investment advice, and because investment decisions for a Fidelity fund are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any Fidelity fund. Neither Fidelity nor the speaker can be held responsible for any direct or incidental loss incurred by applying any of the information offered. Please consult your tax or financial advisor for additional information concerning your specific situation.

Past performance is no guarantee of future results.

Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.

Diversification and asset allocation does not ensure a profit or guarantee against loss.

As of March 31, 2014 the Fidelity Select Biotechnology Portfolio held 11.7% of assets in Amgen, Inc., and 2.3% in Regeneron Pharmaceuticals, Inc.

Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.

Because of their narrow focus, sector funds tend to be more volatile than funds that diversify across many sectors and companies.

Stock markets, especially foreign markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Sector funds can be more volatile because of their narrow concentration in a specific industry.

The S&P 500® Index, a market capitalization–weighted index of common stocks, is a registered service mark of The McGraw-Hill Companies, Inc., and has been licensed for use by Fidelity Distributors Corporation.
The MSCI U.S. IM Biotechnology 25/50 Index is a modified capitalization-weighted index of stocks designed to measure the performance of biotechnology companies in the MSCI U.S. Investable Market 2500 Index. The MSCI U.S. Investable Market 2500 Index is the aggregation of the MSCI U.S. Large Cap 300, Mid Cap 450, and Small Cap 1750 indexes.
The NASDAQ Biotechnology Index includes securities of Nasdaq-listed companies classified according to the Industry Classification Benchmark as either Biotechnology or Pharmaceuticals with market capitalizations of at least $200 million and daily trading volume of at least 100,000 shares.
MSCI® U.S. Investable Market Biotechnology Index is a market capitalization-weighted index of stocks designed to measure the performance of Biotechnology companies in the MSCI U.S. Investable Market 2500 Index.
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